DERIVATIVES & RISK MANAGEMENT FALL 2015

Transcription

1 DERIVATIVES & RISK MANAGEMENT FALL 2015 FIN-674 Derivatives & Risk Management (3 credits) Professor Michel A. Robe Phone: Office Hours: W 1-2:30PM & 5:15-6:15PM, Th. 8:45-9:45AM and by appointment. Home page: Prerequisites This master s level course is very quantitative. Its demands on students are some of the highest among finance courses Fixed Income (FIN-683) is comparable in that respect. Nevertheless, the sole formal prerequisite for Derivatives is to have obtained a grade of B or better in Financial Management (FIN-614). Securities & Investments Analysis (FIN-672) is NOT a prerequisite. Still, having already taken that course may be helpful in the discussion of interest-rate derivatives. I therefore encourage students who have not done so, to read on the course website the two primers that I have written on the relevant material from that course. For group cases, proficiency with Excel is critical. Knowledge of mathematical statistics and at least some prior knowledge of calculus are also important: stochastic calculus will be introduced and applied in the last part of this course. I have posted two primers on calculus, with some exercises, on the course webpage as a way for students to refresh their knowledge. A good place to check one s readiness is to look at the Wikipedia page on mathematical derivatives: Learning Outcomes Following the intense turmoil that started manifesting itself in financial markets in August 2007, individuals skilled at pricing derivatives and at using these instruments for risk management remain in high demand on Wall Street and elsewhere. To wit, exchange-traded options volumes reached successive historical records from 2009 to 2011 (though volume was down 15% in 2012, it remained much higher in 2013 and 2014 than in 2009). In this course, MBA and MSF students receive a thorough introduction to the valuation of, and to key hedging and risk management strategies based on, key derivatives contracts: futures, forwards, swaps and options. Students are exposed to material that any player in the investments industry from a financial analyst at Goldman to a pension fund advisor to a bond portfolio manager at CSFB or Fannie/Freddie to a corporate treasurer will find useful. The course includes a deeper coverage of some tools that are covered (with different emphases) in some other finance courses (e.g., Financial Management, Investments or Fixed Income), as well as new tools not seen elsewhere in the curriculum. Because one of the outcomes is to be able to use derivatives in actual business life, students are asked to carry out the analysis of two HBS cases. Logically, the study of instrument pricing techniques and of the institutional background in which derivatives professionals operate should precede the study of how these professionals do or ought to behave. The course is organized accordingly

2 Forwards, Futures and Swaps. After an introduction and a brief review of general finance concepts, Parts I and II of the course discuss forward and futures contracts. We cover the theoretical and practical differences between forward and futures, the microstructures of their markets (including market participants and trading), and pricing both relative to current or expected future spot prices and relative to one another. We first discuss the specifics of several contracts. A significant amount of time is devoted to FX forwards, interest-rate forwards and futures, and equity (stock-index) futures, as well as commodity futures an asset class that has grown by leaps and bounds in the past 10 years. We then introduce key hedging tactics and strategies. (Some of the materials covered will tie in neatly with FIN-684 Fixed Income) Part III deals with swaps. Building on the material covered at the end of Part II, we start with interest rate (IR) swaps, and then move on to more complicated currency swaps. We contrast the latter with the simpler FX swaps (a much simpler foreign exchange or forex market transaction). Mechanics, pricing, market microstructure and purported advantages and drawbacks of both types of swaps are presented. Next, we learn how to value all those swaps. Finally, the impact of swap deals on companies all-in costs of financing and deal-valuation is discussed. Time permitting, we will also introduce commodity swaps; credit-default swaps (CDS); and we will discuss credit risk management both in swap transactions and using CDS s. This first half of the course is rounded off by a MT exam (taken on the Wednesday right before AU s Fall Break, i.e., on October 7 th ) and a first practical case that focuses on (but is not limited to) FX-based and index instruments (it is due three weeks after the MT 3PM on Monday, November 2 nd ). Options. After a brief introduction, Part IV of the course presents option contracts. We cover the theoretical & practical differences between options & forwards or futures and between calls & puts, and discuss the payoff profiles of various investment strategies involving options (butterfly spreads, straddles, etc.). We then learn about practical aspects of option markets microstructure (including participants, trading and quotes). We conclude Part IV by discussing how default risk is controlled in option contracts. Part V focuses on option pricing fundamentals. After identifying the basic determinants of option prices, we review some key option pricing principles such as put/call parity. We then introduce the famous Black & Scholes (B&S) option pricing formula, before discussing the idea behind binomial option pricing, and the mechanics of risk-neutral valuation using binomial trees. Part VI then deals with practical methods to value real-life options and carry out some key hedging strategies. We identify situations when at least some of the assumptions behind the B&S model need to be relaxed, and show that binomial option pricing techniques can often still handle those circumstances. We cover options on dividend-paying stocks as well as options on stock market indices; options on currencies; and, options on futures. Part VII is devoted to options-based hedging. We start by introducing continuous-time finance, and show how stochastic calculus is used to find the correct price of seemingly complicated derivative securities. Next, we establish the equivalence of the binomial and Black-Scholes option pricing techniques when the assumptions needed for the B&S model are verified. At that point, we will have the theoretical underpinnings necessary to discuss the Greeks and to analyze essential options-based hedging strategies

3 Time permitting, Part VIII we will introduce interest rate derivatives including swaptions. Some derivatives professional(s) may join us for a guest lecture. A second, real-life HBS case is then used to apply the material learned in this second half of the course. A final exam rounds off the module. Note: Real Options The present course focuses on derivatives as financial instruments, i.e., for portfolio investment and risk management purposes. A corporate finance application of the second part of the course is Real Options. That topic is typically covered in FIN-573 Valuation, a course that uses the material from Parts V-VII to support traditional investment evaluation techniques (e.g., NPV analysis) and to help improve corporate capital investment decisions. Course Materials Required text: Options, Futures & Other Derivatives - 9 th ed., by John C. Hull. Prentice-Hall, (H9). The 6 th, 7 th and 8 th editions of the book, which are only a few years older (2007, 2008, and 2011, respectively), are acceptable substitutes. Note: Text errata can be found at: Recommended supplementary text: Investments 10 th ed., by Zvi Bodie, Alex Kane & Alan Marcus. McGraw Hill/ Irwin, 2014 (BKM) The required text (H9) is the industry standard, used by practitioners and academics around the world. It (H9) is available at the bookstore. BKM is a Master s-level, CFA-recommended textbook on investments and provides a good introductory (less mathematical) treatment of some of the topics covered in class. Starting next week, an earlier edition of this supplementary text (BKM4) will be on the 2-hour reserve at the library. The latest edition (BKM10) is available at the bookstore if you wish to buy it. Additional materials will be handed out in class. In addition to the textbooks and transparencies, I have prepared a reading packet (RP) containing additional materials. These papers are based primarily on other, more specialized textbooks. The reading packet does not include articles from practitioner-oriented journals (such as Journal of Portfolio Management and the Financial Analysts Journal). Copies of such articles have instead been grouped in a second in-depth library packet (LP). Starting after Labor Day, papers from the RP and LP may all be downloaded directly from an Online Library accessible through the class home page. Whereas the RP does constitute exam material, the LP does not. Rather, the LP is intended to round out interested students' awareness of important issues faced by practitioners. Derivatives make up an especially dynamic area, and students are therefore urged to follow current developments in the press. This includes reading the following publications: RISK Magazine (a key source of information for market participants), The Economist (weekly, mostly pay site), The Financial Times ( free registration), The Wall Street Journal ( pay site). Barron s, Euromoney and Value Line s Investment Surveys are other good sources of investment news. Other newspapers may also be useful for the purpose of the class, but often lack significant amounts of relevant information

4 While I encourage students to keep abreast of financial news, exam questions will not require that students be knowledgeable of current affairs unless, of course, that information has been discussed and analyzed in class. Transparencies The lectures shall be based partly on transparencies. Except for the first two lecture sets, I shall make these transparencies available on the Web as the class progresses. Transparencies for every lecture can be downloaded COB the Friday before (i.e., Fridays at 5 PM). You will probably want to print a paper copy of the relevant transparencies before each class to help in note taking. Grading Grading is on a curve. The weights for the final grade are as follows: Group assignments (numerical cases): 22.5% each MT and Final exams: 25 % each Class participation: 5 % Mid-way through the course, there shall be a single MT exam on the week of Fall Break (i.e., the week of October 5 th 9 th, 2015). That exam shall be closed book. Each student, however, may bring in a calculator and one 8.5"x11" cheat sheet. One side of the sheet may be filled with anything the student wishes, but must be handwritten by him/her (no photocopying). There shall also be one take-home final exam. That exam shall be handed out on the last day of classes, and the solution is to be handed on the final-exam day listed in AU s Schedule of Classes. The takehome should take approximately 2-3 hours to complete. Students who have a valid reason to not take an exam on the planned day (e.g., documented illness, death of significant other, or key job interview) should contact me so that I can coordinate a single make-up exam for all students in a similar situation. In addition, since I wish to emphasize practical skills, students shall complete two cases (analytical + quantitative) that use actual data. To reflect how most companies conduct business, students shall form groups to handle these assignments. Groups shall comprise three to five students no fewer, no more. Groups shall their composition to me by October 1 st. Once groups have formed, their composition is not allowed to change. I reserve the right to handle all group-related problems. General suggestions for preparing the assignment will be included with the latter. Each group is to return its write-up and supporting Excel spreadsheets (Windows or Mac format) by Case #1: Case #2: Assignments that are late shall not be graded. Monday, November 2 nd by 3PM (i.e., 3 weeks after the MT exam); The last day of the final-exams period by 3PM. In order to approximate business practice, where an individual's performance evaluation reflects not only the opinion of supervisors but also that of peers, group members shall evaluate one another. Each group member's grade on a case will thus reflect overall group performance and other members' opinions. Evaluation sheets are provided at the end of this handout. To help students prepare for the assignment and the exams, I will hand out a series of practice sets with solutions. These sets will not be graded, but students are strongly encouraged to try hard to - 4 -

5 solve them and to use office hours to discuss any problems they may have doing so. One of the best self-tests for a student of his or her command of the material before a case or an exam is whether he or she can handle the questions of the relevant practice sets. The questions on the exam will cover the reading material, and will be very similar to those in the practice sets. Class participation is important and will be explicitly rewarded (5% of the total grade). Effectively, the class participation grade may change a grade near a cutoff. While I do not penalize occasional tardiness, a pattern of repeated unexplained late arrivals shall negatively impact the class participation grade. Understandably, job search or other obligations may occasionally conflict with class. It is each student s responsibility to find out from his/her classmates what has been missed during the absence. Honor Code By registering for the class, students promise to abide by the American University Honor Code. Cases: Because I have taught courses similar to Derivatives at McGill and American Universities, solutions or solution keys to the group assignments may exist. Any use of, or reference to, existing solutions (whether written by me or by former students) is prohibited. Students within a group shall be judged, partly, by how well they work together. Members of any given group, however, shall not collaborate with any other group or person. Exam: The MT exam shall be closed book, subject to the caveat in the previous section. The final is an open book, take-home exam. Needless to say, students are not allowed to collaborate with anyone once the exam has been handed out to students for completion. Failure to respect these requirements shall be considered a severe violation of the University Honor Code and dealt with accordingly. If you have any questions about academic integrity or standards of conduct in this course, please visit and discuss your concerns with me. Course Outline A detailed list of topics covered in class and related readings follows. Only readings in Hull (in the edition you have chosen H6, 7, 8 or 9) and in the Readings Packet (the notes handed out in class) are mandatory. Other readings, including those in BKM and in the Library Packet, are recommended but will not constitute exam materials. Students should review background materials in Hull (interest rate concepts: H9 pp & 96-98; H8, pp & 93-6; H7: pp & 91-3; H6: pp & 93-4; bond quotes: H9 pp ; H7 and H8: pp ; H6: ; duration & convexity: H8, pp ; H7, pp ; H6: pp , H9 pp short sales: H9 pp ; H8: pp ; H7 & H6: pp ) and in the BKM Quantitative Review (BKM5 pp & ; BKM4 pp & ), as well as two course primers I have written for this module (on financial markets and on fixed-income securities). I shall cover these materials only cursorily in class

6 Course Outline Introduction Syllabus Overview Derivatives & Basic Finance Principles Strongly recommended Supplementary Reading: Futures Primer Part 1 Financial Markets (LP and web) Forward Fundamentals Part I: Forwards (Weeks 1-3) Contracts (H9: pp. 5-7; H8: pp. 5-7; H6 & H7: pp. 3-6) Market participants (H9: pp & 15-6; H8: pp & 15-6; H7: pp & 14; H6: pp. 2, 8-10 & 14) Forward mkt microstructure (H9: pp. 2-4; H8: pp. 2-4; H7 & H6: p.2; H8: pp. 2-4) FX forward quoting conventions (H9: pp. 5 & 43; H8: pp. 5 & 42; H7: pp.4 & 40; H6 p.41) Risk control collateralization and netting in OTC contracts: (H9: pp & 811-2; H8: pp & 535-6; H7: pp & 511-2; H6, pp & 494-6) Highly Recommended Supplementary Reading: What can go wrong? H9 pp. 18 (SocGen), 34 (LTCM), and (largest derivatives losses) H8 pp. 17 (SocGen), 31 (LTCM), and (largest derivatives losses) H7 pp. 15 (Barings), 30 (LTCM), and Hedgers or speculators? MetallGesellschaft (H8 p.67, H7 p.66) Forward Pricing Forward vs. current spot general principles forward spot parity or cost of carry relationship (H9: pp. 6-7, 15-6 & 104-9; H8: pp. 6-7, 15-6 & 104-9; H7 and H6: pp. 5-6 & 101-7) special cases currencies and commodities IRP theory (H9: pp. 107 & 114-7; H8: pp. 107 & 114-7; H7 and H6: pp. 107 & 112-5) + practice commodities (H9: pp ; H8: pp & ; H7 and H6: pp ) valuing forward contracts (H9: pp ; H8: pp ; H7 and H6: pp ) Forward vs. expected future spot convergence property (H9: pp & 121-3; H8: pp & 121-3; H7 & H6: pp & ) forward parity theory and practice (RP and web) contango, backwardation, and term structure of futures prices (H9: pp. 36 & 121-3; H8: pp. 35 & 121-3; H7: pp & 121; H6: pp & 121) Required Supplementary Reading: A note on parity conditions (RP and web); Chapter 33, commodities - 6 -

7 Suggested Supplementary Readings: Long-Horizon Uncovered Interest Rate Parity (LP and web) Adjusted Forward Rates as Predictors of Future Spot Rates (LP and web) Energy Derivatives a PowerPoint overview of crude oil and gas futures (LP and web) Futures vs. Forwards Part II: Futures (Weeks 3-5) Futures: binding contracts (H9: pp. 7 & 41; H8: pp. 7 & 41; H7: pp. 6 & 39-40; H6: pp. 6 & 40-1) or bets? Market microstructure (H9 & H8 & H7: pp. 2-4 & Chapter 2; H6: pp. 21-3, 26-37) exchange-based trading (H9: pp. 2, 6, 20; H8: pp. 2, 7, 21 & 817; H7: pp. 1-2, 6, 21 & 799; H6: pp. 1-2, 6, 21 & 767) standardization (H9, pp. 24-6; H8, pp. 24-6; H7 and H6 pp. 23-5) risk control marking to market (H9: pp ; H8: pp ; H7 and H6: pp. 26-9) clearing house (H9 & H8 & H7 & H6 pp ) collateralization & netting in OTC forwards (H9: pp & 811-2; H8: pp & 535-6; H7: pp & 511-2; H6, pp & 494-6) regulation (H9: pp (excl. taxes); H8: pp ; H7: pp. 36-7; H6 pp. 37-8) Pricing/valuation (H9: pp & 123; H8: pp & 124; H7: pp & 126-7; H6: pp & 127-8) Required Supplementary Reading: A note on the marking to market of futures contracts (RP and web) Suggested Supplementary Reading: Chapters 22 and 23 Futures (BKM 4 or BKM5) Futures: Some Accounting & Tax Considerations (H9: pp. 41-2; H8: pp. 40-1; H7: pp. 37-9; H6: pp ) Specific Futures Contracts Stock Index Futures Fundamentals (H8: pp ; H8: pp. 60-1; H7: pp ; H6: pp. 60-2) International aspects (stock index futures & synthetic international portfolio diversification) - 7 -

8 Pricing (H9: pp ; H8: pp ; H7 & H6 pp ) Suggested Supplementary Reading: The S&P 500 Index Futures on the CME (LP and CME s web site) Futures trading & Pension Funds: Discussion (LP and CME s web site) Futures trading & Mutual Fund: Legal aspects (LP and CME s web site) Commodity Futures Fundamentals (H9: pp. 24-7; H8: pp. 24-6; H7 & H6 pp. 23-5) Price quotes (H9: pp. 33-8; H8: pp. 33-7; H7: pp. 31-4; H6: pp. 32-4) Pricing (H9: pp ; H8: pp ; H7: pp ; H6: pp ) Pricing of energy futures (as time allows; H9: pp ; H8: pp ; H7: pp ; H6: pp ) Suggested Supplementary Reading: Energy Derivatives a PowerPoint overview of crude oil and gas futures (LP and web) Mid-term Exam (Week before Fall Break) Interest Rate Futures Contracts on short-term interest rates Forward interest rates (H9: pp. 81-2; H8: pp. 84-6; H7: pp. 82-5; H6: pp. 84-7) Forward rate agreements FRA s (H9: pp ; H8: pp. 86-9; H7: pp. 85-7; H6: pp. 87-9) Eurodollar & T-Bill futures (H9: pp ; H8: pp ; H7: pp ; H6: pp ) Contracts on long-term interest rates T-Bond and T-Note futures (H9: pp ; H7 & H8: pp ; H6: pp ) Required Supplementary Reading: Futures Primer Part 2 Bonds (LP and web) A note on FRA's (RP and web) this reading is strongly recommended Fixed income background materials in Hull: interest rate concepts (H9 pp & 96-98; H8: pp & 93-6; H7: pp & 91-3; H6 pp & 93-4) quoting conventions for fixed income (H9 pp.132-3; H7 & H8: pp ; H6 pp ) - 8 -

9 Futures-based Hedging Types of traders: Hedgers, Speculators, and Arbitrageurs (H9: pp 11-17; H7 & H8: pp. 9-15; H6: pp. 8-15) Why hedge? (H9 pp. 11-2, 51-4 & 66-7; H8: pp ; H7: pp ; H6: pp. 50-2) Long and short hedges (H9 pp. 50-1; H8: pp. 46-9; H7: pp. 46-7; H6: pp ) Basis and choice of futures (H9 pp. 54-8; H8: pp. 52-6; H7: pp. 51-4; H6: pp. 53-6) Own vs. cross hedges (H9 pp ; H8: pp. 56-9; H7: pp. 54-8; H6: pp ) Rolling hedges forward (H9: pp. 68-9; H8: pp. 64-7; H7: pp. 64-5; H6: pp. 67-8) Specific hedging techniques hedging a stock portfolio (H9:pp ; H8:pp. 60-5; H7:pp. 60-4; H6: pp. 62-6) duration-based hedging strategies (as time allows; H9: pp & 91-94; H8: pp ; H7: pp ; H6: pp & 142-3) Required Supplementary Reading: hedging portfolios of assets/liabilities (as time allows; H9: pp. 147; H8: p. 143; H7: pp ; H6: pp ) Fixed income background materials in Hull: duration & convexity (H9: pp ; H8: pp ; H7: pp ; H6 pp ) Part III: Swaps (Weeks 6-8) Fundamentals Swap Valuation Contracts & market microstructure Swap mechanics interest rate swaps (H9: pp & 164-6; H8: pp ; H7: pp ; H6: pp & 173-4) currency swaps (H9: pp ; H8: pp ; H7: pp ; H6: pp & 174) swaps vs. long-dated forward contracts Commodity or equity swaps (as time allows; H9: pp. 167; H8: p. 175; H7: pp ) Credit Risk (as time allows; H9: pp ; H8: pp ; H7: pp ; H6: pp ) Interest rate swaps (H9: pp.164-8; H8: pp ; H7: pp ; H6: pp ) Overnight Index Swaps (OIS, as time allows; H8, pp ) Currency swaps (as time allows; H9: pp ; H8: pp ; H7: pp ; H6: pp ) Commodity swaps - 9 -

10 Forward vs. swap hedging (as time allows class handout) Fundamentals Netting vs. hedging Hedging of net exposure Swaps and Corporate Financing (as time allows class handout) All-in cost of capital Basis-Point equivalence method for currency swaps Required Supplementary Reading: Swaps vs. Long-Dated Forwards (RP and web) Bank & Counterparty currency swap (RP; as time allows) Suggested Supplementary Reading: Swap Credit Risk: An Empirical Investigation on Transaction Data (LP and web) Chapter 23, Section 23.5 Swaps (BKM 5) Case I is due on Monday, November 3 rd at 3PM Basics (H , Chapter 1) Part IV: Option Fundamentals (Weeks 9 & 10) Derivatives Terminology & Market participants (H9: pp & 14-5; H8: pp. 7-9 & 14-5; H7: pp. 6-8 & 13-4; H6: pp. 6-8, 10-1 & 13-4) Option contracts (H9: pp. 8-11, & ; H8: pp. 7-9, & 199; H7: pp. 6-8, & 184; H6: pp. 6-8 & 181-3) Option payoffs (H9: Chapter 12; H8: Chapter 11; H6&7: Chapter 10) Naked positions (H9:pp.8-11 & ; H8: pp ; H7: pp ; H6: pp. 8 & 181-5) Covered positions covered calls and protective puts (H9: pp ; H8: pp ; H7: pp ) Spreads bulls, bears and butterflies (H9: pp ; H8: pp ; H7: pp ) Combinations straddles, strips & straps, strangles (H9: pp ; H8: pp ; H7: pp ) Collars (as time allows) Option market microstructure (H9: Chapter 10 H8: Chapter 9; H6&7: Chapter 8) Option exchanges (H9: pp. 2-3 & 223-6; H8: pp. 2-3 & 203-6; H7: p.2 & ; H6: & 198-9) vs. OTC options (H9: pp ; H8: pp. 210; H7: p. 195) Underlying assets (H9: pp ; H8: pp. 199; H7: p.184; H6: pp ) Specifications and quotes (H9:pp ; H8:pp ; H7. pp ; H6: pp & 190-1)

11 Dividends, stock dividends and stock splits (H9: pp ; H8: pp ; H7 pp ; H6: pp ) Clearing house (H9: pp ; H8: pp ; H7 p. 192) Option-like securities, including warrants (H9: pp ; H8: pp ; H7: pp ; H6: pp ) Suggested Supplementary Reading: Option contracts & market microstructure (BKM4 pp ) Option pricing (BKM4 pp & 632-5) Option-like securities, including warrants (as time allows, BKM4 pp ) Option strategies (additional readings, BKM4 pp ) Part V: Option Pricing Basics (Weeks 10-12; H8: Chapter 10) Key determinants of option prices (H9: pp ; H8: pp ; H7: pp ; H6: pp ) Upper and lower bounds for option prices Put call parity Hard and soft floors (H9: pp & ; H8: pp & ; H7: pp ; H6: pp ) Early exercise (H9: pp. 241 & 250; H8: pp. 221 & 230; H7: pp ; H6: pp ) European calls and puts (H9: pp ; H8: pp ; H7: pp ; H6: pp ) Extensions (H9: pp. 250; H8: pp. 230; H7: p. 215; H6 pp. 215 & 219) Stock option prices European calls -- Black & Scholes (H9F: pp ; H8: pp ; H7: pp ; H6: pp ) Put call parity: European call price & European put price (H9: pp ; H8: pp ; H7: pp ; H6: pp ) What about American options? Calls vs. puts & Black s approximation (H9: pp ; H8: pp ; H7: pp ) Binomial trees and Risk neutral pricing (H8 Chapter 12; H6&7: Chapter 11; H5 Chapter 10; H4 Chapter 9) One-period trees (H9: pp ; H8: pp ; H7: pp ; H6: pp ) Risk neutral valuation principle (H9: pp ; H8: pp ; H7: pp ; H6 pp ) Two- and multi-period trees (H9: pp & 286-9; H8: pp & 265-8; H7: pp & ; H6 pp ) & dynamic hedging (H9: pp ; H8: pp ; H7: pp ; H6 pp ) Options on different assets (H9: pp ; H8: pp ; H7: pp )

12 Parts VI: Practice of Option Pricing (Weeks 12 & 13) Estimating tree parameters (H9: Chapter 21; H8: Chapter 20; H7: Chapter 19; H6: Chapter 17) Non-dividend paying asset (H9: pp ; H8: pp ; H7: pp ; H6 pp & 392-7) Dividend-paying asset Binomial trees and optimal early exercise Continuous payout rate (H9: pp ; H8: pp ; H7: pp ; H6 pp ) Discrete-sized dividends: known yield vs. known value (H9: pp ; H8: pp ; H7: pp ; H6: pp ) Puts (H9: pp & 453-4; H8: pp & 430-2; H7: pp & 410-2; H6: pp & 401-5) Calls (H9: pp & ; H8: pp & 436-7; H7: pp & 416-7; H6: pp & 401-5) Time-varying interest rates (as time allows, H9: pp ; H8: pp ; H7. pp ; H6 pp ) Alternative tree constructions: trinomial trees vs. adaptative mesh (as time allows, H9: pp ; H8: pp ; H7. pp.422-5; H6 pp ) Parts VII: Black-Scholes and Option-Based Hedging Strategies (Weeks 13 & 14) Continuous-time finance Executive summary (this part IS NOT exam material but crucial for the next part) Wiener processes (H9: pp ; H8: pp ; H7: pp ; H6: pp ) Ito s lemma (H9: pp & ; H8: pp & 297-8; H7: pp & 275-6; H6: pp & ) Black-Scholes-Merton model (H9, Chapter 15; H8, Chapter 14; H7 & H6, Chapter 13) Volatility smiles & smirks (as time allows; H9, Chapter 20; H8, Chapter 19; H7, Chapter 18; H6, Chapter 16) Greek Letters and various hedging strategies (this part IS exam material; H9, Chapter 19; H8, Chapter 18; H7, Chapter 17; H6, Chapter 15) Parts VIII: Interest-rate Derivatives (as time allows, Weeks 13 & 14) Interest rate derivatives Basic models of the short rate (as time allows, H9 Chapter 31; H8 Chapter 30; H7 Chapter 30) European swap options (as time allows) Interest rate derivatives Heath-Jarrow-Morton & Libor Market Model HJM model (as time allows, H9 Chapter 32; H8 Chapter 31; H7 Chapter 31) Credit derivatives (H9, Chapters 24 & 25; H8, Chapters 23 & 24; H7, Chapters 22 & 23)

13 Articles in the Reading Packet (LP) Website handouts IRP note A note on parity conditions, 4 pp., AU-2013 A note on the marking to market of futures contracts, 6 pp., AU-2013 A note on FRA's, 7 pp., AU-2013 Swaps vs. Long-Dated Forwards, 6 pp., AU-2007 Futures Primer Part 1 Financial Markets, 10 pp. Futures Primer Part 2 Bonds, 12x6 pp. Articles in the Library Packet (LP) Recent background articles are available from the Online Library and accessible through the course s website. The older articles listed below are oldies but goodies can be obtained from AU s library. Buser, S., G.A. Karolyi & A. Sanders (OSU) Adjusted Forward Rates as Predictors of Future Spot Rates Working Paper, Ohio State University, 1996 Chicago Mercantile Exchange The S&P 500 Index Futures on the CME Futures trading & Pension Funds: Discussion Futures trading & Mutual Fund: Legal aspects Cossin, Didier and Hughes Pirotte, (Institute of Banking & Financial Management, U Lausanne; Swap Credit Risk: An Empirical Investigation on Transaction Data Journal of Banking and Finance, 21 (10), October 1997, pp Jorion, Philippe; Roisenberg, Leonid (UC Irvine; Bankers Trust Investment Management, NY) Synthetic International Diversification Journal of Portfolio Management; 19 (2), Winter 1993, pp Sanford C. (Bernstein & Co, NY) The Problem with Emerging Markets Indexes Journal of Portfolio Management, 24 (2), Winter 1998, pp

14 Group Participation Form Your name: Other group members: A. How were duties assigned? Explain briefly. B. Were duties evenly distributed? Explain briefly. C. What specific duties did you perform? Explain briefly. D. Did you participate fully in the case preparation? If not, why not? Did all members participate fully? If not, who not? Why not?

15 E. On a scale of 1 to 10, with 10 being the highest and a note of 4 or less denoting a serious problem, how would you rate group members in the following areas: 1. effort expended / time contributed Yourself reliability (e.g., completing assigned tasks, showing up for meetings, etc.) Yourself quality of written and/or spreadsheet output Yourself quality of contribution to group discussions Yourself mastery of content (e.g., level of comprehension of assignment questions and materials, etc.) Yourself ability to work well in your group Yourself

16 Pandemic Planning (University statement) In the event of a declared pandemic (influenza or other communicable disease), American University will implement a plan for meeting the needs of all members of the University community. Should the University be required to close for a period of time, it is committed to ensuring that all aspects of its educational programs will be delivered to AU students. These may include altering and extending the duration of the traditional term schedule to complete essential instruction in the traditional format and/or use of distance instructional methods. Specific strategies will vary from class to class, depending on the format of the course and the timing of the emergency. I shall communicate class-specific information to students via AU and Blackboard. In turn, students are required to inform me immediately of any absence due to illness. Students are responsible for checking their AU regularly and keeping themselves informed of emergencies. In the event of a declared pandemic or other emergency, students should refer to the AU Web site (www. prepared. american.edu) and the AU information line at (202) for general university-wide information, and contact me (the Dean s office) for course- (KSB)-specific information. Academic Support and Disability Support Services If you experience difficulty in this course for any reason, please don t hesitate to consult with me. In addition to the resources of the Finance department, a wide range of services is available to support you in your efforts to meet the course requirements. Academic Support Center (x3360, MGC 243) offers study skills workshops, individual instruction, tutor referrals, and services for students with learning disabilities. Writing support is available in the ASC Writing Lab or in the Writing Center, Battelle 228. Counseling Center (x3500, MGC 214) offers counseling and consultations regarding personal concerns, self-help information, and connections to off-campus mental health resources. Disability Support Services (x3315, MGC 206) offers technical and practical support and assistance with accommodations for students with physical, medical, or psychological disabilities. If you qualify for accommodations because of a disability, please notify me in a timely manner with a letter from the Academic Support Center or Disability Support Services so that we can make arrangements to address your needs